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Mental accounting can be thought of as the intersection of behavioral psychology and economics. It is the discipline that examines how people think about money and financial transactions, in an effort to find ways for the thought processes and the operation of financial instruments to be brought into closer alignment with each other, so that people experience more positive outcomes. This field can be a challenging one because its focus is on a system that continually reshapes itself: People’s manner of thinking about money affects the way they use money, but at the same time, the opposite is true—the way people use money affects how they think about it. Ultimately, the reason why social scientists are interested in mental accounting is because it provides insight into the psychology of choice: how people make decisions in the allocation of scarce resources to satisfy a diverse array of needs and wants.
A sizable portion of the study of mental accounting is devoted to determining the reasoning that causes many people to act contrary to their interests, and even to their expressed intentions, in matters of finance. For example, most people are aware that they should save money for unforeseeable emergencies, that they should avoid overspending and taking on large amounts of debt, and that they should invest their money in the assets that provide the greatest amount of return at the lowest risk.
Nevertheless, the vast majority of consumers do not follow any of these strategies consistently, instead rationalizing, procrastinating, and making excuses for not doing what they know they should do. Mental accounting studies the reasons why people do these things, and it also analyzes the mechanisms they use, such as claiming not to have enough time or money.
Mental accounting had its origins in the work of the economist Richard Thaler, who observed that people tend to think of their finances in separate amounts and each amount is differentiated by a special purpose (and often by a level of risk that the person considers acceptable for that amount). Contrary to common sense, which would suggest that all of one’s funds are identical and interchangeable, mental accounting shows that people think of some money as being set aside for “safe” purposes, while other money can be used in a more risky fashion, such as investing in the stock market, purchasing lottery tickets, or gambling.
One of the principles of economics is known as fungibility. Fungibility means that a resource is interchangeable, as with currency—one dollar can be substituted for another; if one wishes to save $100 from a $500 paycheck for a vacation fund, it doesn’t matter which hundred dollars of the five hundred are saved, because they are all the same. Mental accounting involves choices that seem contrary to common sense precisely because such accounting contradicts the concept of fungibility, by treating different amounts of money as if they had unique functions and qualities. A person might view his or her paycheck as a collection of such amounts: $50 for the water bill, $100 for electricity, $1,000 for rent, and so forth.
One of the foundations of mental accounting theory is the concept of framing. Framing refers to the ways we choose to look at an issue. The way we frame an issue largely determines how we feel about that issue and how we will behave in circumstances where that issue is a situational factor. For example, there are at least two ways of framing the issue of the cost of life insurance. One way to frame it would be to see it as a financial burden that may never be of any use, and even if it is of use, it will be when one is dead and beyond the need for money. On the other hand, one could also frame the cost of life insurance as providing a deep and abiding sense of peace, as one can rest assured that one’s family will be provided for in the event of one’s death.
Framing affects almost every aspect of our interactions with money, especially when two or more people are cooperating to allocate limited financial resources, because different people are likely to frame a given transaction in different ways. A husband out shopping with his wife might see that the $500 set of golf clubs he has had his eye on are on sale at a 50-percent discount. He will frame this as a huge savings and will be eager to take advantage of the deal. His wife, on the other hand, may frame the situation as a large purchase (e.g., $250) that they cannot afford right now. Experts in mental accounting are accustomed to helping people reconcile contrasting frameworks like these.
An interesting application of mental accounting arises when one studies the different behaviors people exhibit depending on what type of spending they are doing and what they are spending on. Regarding the type of spending, the largest difference seems to be between the behavior of those who spend using credit cards and those who use cash. This is usually attributed to the fact that cash represents a concrete value that is easier to keep track of as it is spent, while credit cards allow one to just swipe the card and hurry off on the next errand, without spending too much time considering what has been spent.
Regardless of what funds we use to make purchases, there are some goods and services that people tend to spend more on than they might intend to. Many of these are related to traditions, to issues that have major emotional significance, or both. Expenses that implicate both of these motivators are weddings and funerals—in each situation, we are under great pressure to demonstrate the depth of our feelings through the amount that we spend and to maintain ties with past generations by holding events that compare with theirs in grandeur.
Review Of Accounts
Mental accounting takes note of how often one reviews accounts and confirms the balances they contain. This can be done on whatever schedule the circumstances require (daily, weekly, monthly, annually), but the frequency has an impact on one’s spending patterns and one’s perceptions of that spending. Those who check their accounts more frequently will spend with greater confidence because their knowledge about the funds they have available will be more complete and more current, yet this may cause them to spend less than they would otherwise. Consumers who balance their accounts less frequently often have greater anxiety levels about money (the anxiety is typically a major factor deterring them from more frequent account reconciliation).
Reviewing accounts has a separate significance in mental accounting. It also refers to the ways consumers categorize different expenses and the way they think about individual purchases as they assign them to these categories. Most people who pay more than cursory attention to their finances develop some method of tracking how much they spend on different areas of their lives: housing, utilities, clothing, food, entertainment, and many other categories. Often consumers will have categories particular to their own interests but that would not be useful to most other people. A collector of rare manuscripts, for example, might categorize her budget and set aside different amounts for “folios,” “quartos,” and “octavos,” while an ordinary person could get by with one category for “books.” The types of categories that people create tell us how people think about the money they spend. The same is true of how people characterize transactions as belonging to one category as opposed to another. A successful entrepreneur might put tickets to the opera in the category of “business expense” if he took along a prospective client, but if he took his wife instead, the category might be “entertainment.” Depending on his situation, he might feel less guilty about a business expense than about more discretionary spending on an enjoyable evening with his spouse. Each of these internal calculations and judgments is a potential goldmine of insight for the student of mental accounting.
Types Of Value
Part of the internal calculations we engage in during mental accounting is centered on the differences between the two different types of value we attribute to the act of purchasing a good or service. The one that most people are familiar with is called the acquisition value. This is the amount of money that the purchaser is willing to give up in exchange for obtaining ownership of the good or service; in other words, it is what we think of as a fair price for the commodity. Depending on many factors such as personality, need, stress level, and so forth, two different people are likely to assign very different acquisition values to the same product or service. For example, sports fans would assign a high acquisition value to tickets for seats on the 50-yard line at the Super Bowl, while those not interested in such events would assign a much lower value or no value at all.
Separate and distinct from the acquisition value of a transaction is the transaction value the purchaser assigns to that transaction. Transaction value, rather than an indication of one’s belief about what constitutes a fair price, is an indicator of how good a deal the purchaser believes she has got. It is important to realize that this has nothing to do with the amount being spent—it is a function of the difference between what the purchaser pays and what the purchaser believes she should ordinarily expect to pay. If this difference is positive, it means that the purchaser believes that she has paid less than she would have expected to, while a negative sum for the transaction value indicates that the purchaser feels she has paid more than she should have.
Both acquisition costs and transaction costs play a significant role in mental accounting because they are factors in how people spend their money and how they view the act of spending it in particular circumstances. These issues are also very important for those who are selling products and services, because sellers want to make their offerings coincide as much as possible with consumers’ thinking about acquisition and transaction costs. This is why companies look at both their own costs and their competitors’ prices when deciding how much to charge for goods and services. The ideal price point for a commodity is one that is slightly below the competition but well above the overhead. Placing the price above the overhead obviously means that each sale will generate a profit, but placing the price below that of the competition will make purchasers feel that they are getting a good deal (because competitors’ higher prices will give the impression that those higher prices are set at what the price really should be), that is, their transaction value for the purchase will tend to be positive. Sellers want to sell their products at prices near buyers’ acquisition value (the price they feel they can and will pay) and at a point that will give buyers a high transaction value.
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